Life Settlements 101: What Investors Should Know A Presentation By Morris, Manning & Martin, LLP
What is a Life Settlement? Conceptually, similar to a zero coupon bond. The instrument is purchased at a discount to face value, and no interest or cash flow is received during the holding period. Unlike a bond, the entire investment is not made up front but over time as premium payments are made. Also unlike a bond, the precise timing of maturity can be estimated but is not known for certain.
What is a Life Settlement? Policy Owner Policy Lump Sum Payment Life Settlement Provider Policy Purchase Price Investor Premium Death Benefit Issuing Carrier Insured Periodic Contact Tracking Servicer
Brief History of Life Settlements as an Alternative Asset Class The Early Days (Late 1980s to Mid 1990s) The sale of a life insurance policy in a settlement has been legally sanctioned in the U.S. since the early 1900s, but not until the early 1990s did life insurance policies become recognized as a viable alternative asset class. The market was opaque, inefficient, and valuation models and mortality underwriting were unsophisticated. The Modern Era (Mid 1990s to Mid 2000s) Valuation methodologies evolved and more sophisticated pricing analytics became commonplace. Life expectancy determination techniques continued to evolve and became more accurate. New products, such as synthetics and life settlement back bonds have appeared, and some securitizations have been completed.
History of Life Settlements: Evolution of Valuation Methodologies Conceptually, pricing is simple. What is the face value? How much. is yearly premium? What is target discount rate? How long will the insured live? Three most common pricing methodologies: Deterministic; Probabilistic; and Stochastic.
Valuation Methodologies Deterministic Pricing: The least sophisticated method assumes policy maturity and collection of death benefits at the underlying insured s life expectancy. That is, discounted cash flows are calculated using a fixed non-variable investment horizon. Probabilistic Pricing: This method of pricing incorporates mortality rates rather than life expectancies, and contemplates that death may occur at any future policy duration. A probabilistic settlement price is based on the mortality-weighted cash flow approach used in life insurance pricing and reserving and represents an aggregate of all potential outcomes.
Valuation Methodologies Stochastic Pricing: uses Monte Carlo techniques to repeatedly simulate (typically at least a 1000 times) insured lifetimes from which a distribution of policy outcomes is created. A stochastic settlement price is derived from the distribution and may represent a mean, median, mode, percentile or some other selected result. EXAMPLE: *Assume a 80-year-old woman with a $1,000,000 face policy, a LE of 71 months, minimum annual premium of 7% of face, and a target discount rate of 15%. Deterministic Price = $121,700 Probabilistic Price = $152,200 Median Stochastic Price = $105,000 Mean Stochastic Price = $159,200 *Source of data: Calculating confidence: stochastic pricing methods provide more complete information about life settlement risks and returns. Best s Review August 1, 2004, David Cook and Karen Rudolph
History of Life Settlements: Life Expectancy Determination Accurate life expectancy determination is the single most critical variable in a life settlement investment. Historically, there were four major life expectancy providers, but several new entrants have come to market in the last several years. Mortality determination techniques have evolved as empirical data on cohort mortality for typical life settlors has become available. Significant impact of release of the 2008 VBT
Why Life Settlements as an Investment? Life settlements are not correlated to stock, bond or real estate markets. Life settlements are not directly impacted by changes in interest rates, downturns in the economy, foreign currency fluctuations or volatility in global markets. The assets are issued by highly-rated insurers, with long histories financial stability (recent events notwithstanding).
Performance of Equity Indices vs. Hypothetical Life Settlement Portfolios
The Life Settlement Market Today: Diverse Products Available Numerous Avenues for Investment structures are available to match virtually every investors objectives and risk/reward criteria: Purchasing policies on a one-off basis and assembling into a portfolio. Purchasing pre-existing portfolios. Investments in synthetics (index-linked or policy-linked). Structured notes. Open and closed-end funds.
Due Diligence In Life Settlement Transactions The diligence undertaken in the acquisition of life settlements must reflect the realities of the underlying asset. The historical tendency to shortcut due diligence is now impacting the ability of policy owners to re-sell policies in the tertiary market. Three primary types of risk: Regulatory/Counterparty; Transactional; and Insurable Interest.
Regulatory/Counterparty Risk 43 states regulate (viatical and/or life settlement), but it is still possible to purchase policies without a license in 12+ jurisdictions. Limited consistency in regulation from state-tostate. Investors must be certain that the providers through whom they purchase have the appropriate licenses and regulatory approvals.
Regulatory/Counterparty Risk It is also important to confirm brokers and agents in the acquisition change were appropriately licensed. Currently, there are no states directly regulating investors in life settlements statutes (as opposed to securities laws), but some states (e.g., California, a viatical-only state) only permit the transfer of ownership of a life insurance policy (while not restricting the ability to change the beneficiary) to another Californialicensed provider.
Transactional Risk Each form of policy ownership carries its own unique risks that must be taken into account and mitigated. Individual-owned policies: Has there been a divorce; if so, property settlement agreement reviewed? Liens or encumbrances against the policy owner that could encumber the policy? Is the policy owner in bankruptcy? Has a background check been run?
Transactional Risk Trust-owned policies: Is the trust authorized to sell the policy? Where is the trust situs? Is the trustee properly appointed? Corporate-owned polices: Does corporation have authority to sell the policy without shareholder approval? Has the board of directors authorized the sale? Is the corporation in good standing?
Insurable Interest Risk Insurable interest must exist at the time a policy is issued, or it is null and void. An insurable interest, with reference to personal insurance, is an interest based upon a reasonable expectation of pecuniary advantage through the continued life, health, or bodily safety of another person and consequent loss by reason of such person's death or disability or a substantial interest engendered by love and affection in the case of individuals closely related by blood or by law. O.C.G.A. 33-24-3.
Insurable Interest Risk Some non-recourse premium finance programs are not properly structured to ensure that insurable interest exists, and are considered to be Investor Initiated Life Insurance or Stranger Originated Life Insurance. Beneficial Interest or BI programs involve the purchase of the beneficial in a trust shortly after a policy is issued. These programs remain untested in the courts, but carry significant potential risk.
Insurable Interest Risk Carriers are becoming more aggressive in their challenges where they believe proper insurable interest did not exist at the time the policy was issued. Investors in life settlements should carefully diligence the original ownership of the policy to ensure that there was a valid insurable interest in existence at the time the policy was issued.
Portfolio Risks Ability to hide less desirable policies. Increased due diligence requirements. No control of origination process. Changes in mortality tables can impact values. No control of diversification across disease class, carrier, gender, medical underwriter, etc.
Taxation of Life Settlement Funds: Reducing the Government s Share William M. Winter Morris, Manning & Martin, LLP TREASURY DEPARTMENT CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the Treasury Department, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
U.S. Taxation of Life Settlement Transactions Most Frequently Asked Question: Will I receive capital gains? Initial Policy Owner / Initial Policy Sale Life Settlement Funds and Portfolios Life Settlement Providers
Example Life Settlement Funds Traditional Domestic Fund Offshore Master Feeder Fund U.S. Limited Partners GP Entity Domestic Feeder (DE LP) International Feeder (Cayman Islands Exempted Company) LS Fund I (Delaware Limited Partnership) LS Offshore Fund (Cayman Islands Exempted LP) Policy Portfolio Policy Portfolio 3 rd Party Life Settlement Provider (Sources Policies; Arranges Sale; Provides After-Sale Monitoring)
U.S. Taxation Flow Chart Will I Receive Favorable Capital Gains Tax Treatment? Foreign Investors? Yes Before December 31 2010? No Capital Gain Tax Rates return to 28% level. Policy Sale: Yes CAPITAL GAIN No Foreign Investor or Mixed US & Foreign Conducting a U.S. Business? No Policy Sale or Policy Maturity? Policy Maturity: Is business dealer trading OR investing for own account Trading? Investing for Own Account? (Buy and Hold) Yes Yes Capital Gain? Tax Treatment Uncertain Ordinary Income NO CAP GAIN Profit will be subject to U.S. income tax as ordinary income Tax on Net Income @ Approx. 35% Withholding Tax 30% (subject to Treaty)
U.S. Taxation of Life Settlement Transactions Are you conducting a US Trade or Business? Tax Treaty Definition ( Permanent Establishment ) Code Section 864 Material Factor Test? Trading in Securities and Commodities? (864(b)(2)) All cases not governed by Section 864(b) are left to interpretation of the courts and the IRS Pinchot v. Commissioner, 113 F.2d 718 (2d Cir. 1940) (business activities that are considerable, continuous, and regular are considered trade or business activities) Higgins v. Comm r, 312 U.S. 212 (1941) (a taxpayer that merely kept records, collected interest and dividends, and exercised minimal managerial attention over investments is not engaged in a trade or business)
Achieving Capital Gains for Domestic Fund Traditional Domestic Fund U.S. Limited Partners LS Fund I (Delaware Limited Partnership) Policy Portfolio GP Entity 3 rd Party Life Settlement Provider (Sources Policies; Arranges Sale; Provides After-Sale Monitoring) Factors to Maximize Capital Gains? 1. Partnership Agreement should provide that the General Partner is required to invest monies for the Fund s own account, and to the extent possible, should not engage in the direct regular trading of securities or other investments. 2. Partnership Agreement may grant authority to General Partner to hire investment manager. 3. For purchasing life settlement investments, engage an independent life settlement provider to source, evaluate, and facilitate purchase of life settlement policies. 4. Consider hiring a third party to monitor purchased policies (minimizing Fund s management role). 5. Sell the policy pool in a single sale. 6. As an alternative to 5, consider large but isolated sales of policy blocks. Isolated sales of policy blocks should achieve capital gain; frequent sales (i.e. 3-4 or more sales) may be treated as ordinary income. 7. Recognize that buy and hold to maturity likely will yield ordinary income.
Achieving Capital Gains for Offshore Fund Offshore Master Feeder Fund Domestic Feeder (DE LP) LS Offshore Fund (Cayman Islands Exempted LP) Policy Portfolio International Feeder (Cayman Islands Exempted Company) 3 rd Party Life Settlement Provider (Sources Policies; Arranges Sale; Provides After-Sale Monitoring) Factors to Maximize Capital Gains? 1. Partnership Agreement should provide that the General Partner is required to invest monies for the Fund s own account, and to the extent possible, should not engage in the direct regular trading of securities or other investments. 2. Partnership Agreement may grant authority to General Partner to hire investment manager. 3. Engage an independent life settlement provider to source, evaluate, and facilitate purchase of life settlement policies in US. 4. Engage an independent party to monitor purchased policies (minimizing Fund s management role). 5. Sell the policy pool in a single sale (note: non-u.s. investors generally NOT subject to U.S. tax on sale of policy pool in single transaction). 6. As an alternative to 5, consider large but isolated sales of policy blocks. Isolated sales of policy blocks should achieve capital gain; frequent sales (i.e. 3-4 or more sales) may be treated as ordinary income. Again, non-u.s. investors not subject to U.S. tax. 7. Recognize that buy and hold to maturity likely will yield ordinary income (for non-u.s. investors, this means either US income tax or potential withholding tax).
Revenue Ruling 2009-13 Addresses three situations in which an individual policy owner surrenders or sells a life insurance policy. Ruling that cost of insurance (COI) must be deducted from basis for determining gain if owner sells the policy. Significant issues with determining COI. Ordinary income to extent of cash value, and capital gains on amounts exceeding cash value.
Revenue Ruling 2009-13 Example: $100,000 face policy. $64,000 premium paid. $78,000 cash value. Sold for $80,000. $64,000-$10,000 COI = $54,000 basis. $80,000-$54,000 = $26,000 gain. $14,000 ordinary income (inside build-up just prior to sale). $12,000 long-term capital gain.
Revenue Ruling 2009-14 More relevant to life settlement investors. Three scenarios: Scenario 1: $100,000 face policy purchased for $20,000, and $9,000 premium paid to time of policy maturity. $71,000 received by investor upon death of insured is ordinary income. IRC Section 101(a)(2) applies.
Revenue Ruling 2009-14 Scenario 2: Same as 1, except investor sold policy for $30,000 before policy maturity. Policy is held more than one year and is not held as part of inventory. Investor has $1,000 long-term capital gain. Investor does not have to reduce basis by COI.
Revenue Ruling 2009-14 Scenario 3: Investor is a foreign corporation (no U.S. trade or business). $100,000 face policy purchased for $20,000 and $9,000 premiums paid. Upon maturity, $71,000 of ordinary income considered to be from U.S. sources as fixed or determinable annual or periodical under Code Section 881(a)(1). Unless there is applicable double tax treaty, proceeds will be subject to 30% withholding tax.
Life Settlement Investments and the Capital Markets Ward S. Bondurant Morris, Manning & Martin
Life Settlement Investment Options Direct Purchases of Policies Life Settlement Funds Life-Linked Financial Products synthetic life settlements swaps and other derivatives Securitizations policy-backed securities
Life Settlement Investment Options: Direct Purchases of Policies Life Policy Life Policy Life Policy Agent Agent Agent Broker Broker Settlement Provider Investment Life Policies Investors Advantages Policy selection control Flexibility on policy resale Disadvantages Expensive and time-consuming Portfolio concentration Regulatory/transactional risks Premium funding requirements Uncertain investment maturities
Life Settlement Investment Options: Life Settlement Funds Fund Manager Life Policy Investment Investment Life Policy Providers/ Brokers Life Settlements Fund Investors Life Policy Life Policies Units of life settlement fund Advantages Enhanced liquidity Lower minimum investment Disadvantages High fees/operating costs Portfolio concentration Regulatory/transactional risks Lengthy policy acquisition period
Life Settlement Investment Options: Life-Linked Financial Products Rated Counterparty Cash Flows linked to the survival of a pool of lives * Investor * Payment subject to trigger event Reference Pool of Lives Trigger: Death of a Reference Pool Individual Advantages Scalable investment Diversified portfolio of lives No transactional risk Disadvantages No control of underlying assets Liquidity may be limited Hasn t received significant market acceptance.
Life Settlement Investment Options: Securitizations Policyholders Custodian, Trustee, Escrow Agent Collateral Manager Actuaries Broker Broker Broker Provider Provider Provider Cash to Providers for Policies Sale of Policies Pursuant to Origination Agreements Issuer (Bankruptcy- Remote Vehicle) Stop Loss Cover for Longevity Risk (Optional) Liquidity Facility (Optional) Primary Medical Examiner Duplicate Medical Examiner Cash Transfer Tracking Agent Tax Advisers/ Auditors Counsel or Adviser to Check Inconsistency Between Medical Records & Initial Insurance Application (Sometimes Done by Medical Examiners) State & Local Regulatory Counsel for True Sale Transfer & Compliance Confirmation Investors Interest & Principal Private Placement Agent (for Bonds/Notes Distribution)
Advantages Life Settlement Securitizations: Advantages low minimum investment potentially large portfolio large institutional sponsors structure may be designed to limit some investor risk (longevity, legal, transactional)
Disadvantages liquidity limitations ratings difficulties reputational risk some operational risk Life Settlement Securitizations: Disadvantages potential portfolio concentration risk
Life Settlement Securitizations A.M. Best published: Life Settlement Securitization Rating Methodology Report Three levels of assessment Preliminary Assessment (prior to acquisition of policies) Indicative Rating (when 80% of policies acquired) Long Term Debt Rating (when entire transaction is completed) Factors they believed would affect growth of this market: Increased clarity and standardization of life expectancies Transparency of pricing of life settlements Transparency of fees earned by intermediaries Industry safeguards of personal information Effective industry oversight/self-regulation Establishment of rating agency standards for assessing credit risks
Life Settlement Securitizations DBRS issued Methodology Rating U.S. Life Settlement Securitizations Qualitative and quantitative approaches to reviewing a life settlement securitization transaction Qualitatively, the ratings process focuses on: the operational risk associated with the sourcing, origination and underwriting of the life insurance policies serving as collateral for the rated debt; an assessment of the financial strength of the insurers; a review of the representations and warranties made in the transaction; and a review of the legal structure and opinions. Quantitatively, DBRS has developed a proprietary model evaluating each major dimension of the life insurance policy assets, reviewing stresses of a transaction s priority of payments, based on a set of cash flow assumptions (cash flow stresses address the ability of an issuer to meet its obligations).
Life Settlement Securitizations Legacy Benefits Corporation (2004) Raised approximately $70 million $61.5 million of Class A Notes $8.5 million of Class B Notes 35 Year Maturity Moody s Rated Class A Notes A1 Rated.5.35% coupon Class B Notes Baa2 Rated.6.05% coupon Weighted average age of insureds: 77 $70.3 million in face value of policies Included annuities to help pay interest and premiums
Life Settlement Securitizations AIG securitized approximately $8B in face. Yielded $2B in proceeds. Rated by A.M. Best not publicly released.
Life Settlement Securitizations Currently, multiple unrated securitizations in the process. Several have stalled, and are unlikely to close. Availability of quality product and investor skittishness are contributing factors.
Thank you Jim Maxson 404.504.7671 Jmaxson@mmmlaw.com